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I received the following question yesterday regarding the deductibility of mortgage interest. It's one I've received several times before, so I thought it warranted some attention here.

If I take out a $1,200,000 first mortgage to acquire my principal residence but no home equity loan, am I limited to deducting interest on only $1,000,000 of mortgage, since it is all acquisition debt, or can I treat an additional $100,000 of the mortgage as home equity debt even though it’s “really” acquisition debt?

It’s an interesting question, because Section 163 provides a deduction for “qualified residence interest,” which is further defined as “interest paid on acquisition indebtedness or home equity indebtedness…”

Section 163(h)(3)(B)(i) further provides that acquisition indebtedness is any indebtedness that is incurred in acquiring, constructing, or substantially improving a qualified residence and is secured by the residence. However, Section163(h)(3)(B)(ii) limits the amount of indebtedness treated as acquisition indebtedness to $1,000,000 ($500,000 for a married individual filing separately). Accordingly, any indebtedness described in Section 163(h)(3)(B)(i) in excess of $1,000,000 is, by definition, not acquisition indebtedness.

Under Section 163(h)(3)(C)(i) home equity indebtedness is any indebtedness secured by a qualified residence other than acquisition indebtedness, to the extent the fair market value of the qualified residence exceeds the amount of acquisition indebtedness on the residence. However, § 163(h)(3)(C)(ii) limits the amount of indebtedness treated as home equity indebtedness to $100,000 ($50,000 for a married individual filing separately).

In the question above, it would be reasonable to conclude that interest on only $1,000,000 of the $1,200,000 mortgage would be deductible, because there is only acquisition indebtedness; there is no home equity debt. In two court cases — Pau v. Commissioner, T.C. Memo 1997-43 and Catalano v. Commissioner, T.C. Memo 2000-82 — the Tax Court embraced this exact theory, denying a taxpayer an interest deduction on their mortgage balance in excess of $1,000,000 when there was ONLY acquisition debt.

In Revenue Ruling 2010-25, however, the IRS announced that it would not follow the Tax Court’s decisions in Pau and Catalano. Instead, in the fact pattern above, the IRS will allow the taxpayer to treat the first $1,000,000 of mortgage debt as acquisition debt, and a second $100,000 piece of the same debt as home equity debt, even though it is simply an additional part of the original debt. The theory being that by definition, acquisition debt cannot exceed $1,000,000 for purposes of Section 163(h)(3)(B)(ii).

This means that the first $100,000 debt in excess of that amount satisfies all the requirements of home mortgage debt: it is secured by the residence, it is not acquisition debt, and it does not exceed the FMV of the home.

Thus, even though the taxpayer has only one mortgage with a balance of $1,200,000 that was used to acquire the property, only $1,000,000 is treated as acquisition debt, and the next $100,000 is treated as home equity debt. This gives the taxpayer an interest deduction on an additional $100,000 of debt than was given to the taxpayers in Pau and Catalano.